Tools and Techniques for Controlling Financial Activities

Exercising financial control is one of the important functions of finance department. Controlling of financial activities involves adoption of several strategies and techniques.

Every activity of an orga­nization requires finance and every activity is distinct from each other—different types of tools and techniques are used for controlling different types of financial activities. Some of the major tools are discussed here.

A. Budgetary Control:

A budget is a detailed plan of operations of management policy for a given period of time. It is an estimate prepared in advance for future courses of action expressed numerically. Mere preparation of budgets does not help achieve the goals and objectives of the organization but a certain control must be exercised over these plans. Budgetary control is the control device that compares budgeted figures with actual performances for calculating the variances.

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It is designed in such a way that performances are evaluated through preparation of budget reports. Here predetermined plans are prepared for differ­ent functions of the organization for controlling the business as a whole. Some of the budgets that are prepared for budgetary control are shown in Figure 12.1.

i. Advantages of Budgetary Control:

Budgetary control has the following advantages:

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1. Defining Organizational Goals:

It portrays with precision, the overall aims of the business and determines the targets of performance for each department of the organization.

2. Defining Individual’s Responsibilities:

It lays down the responsibilities of each individual so that everybody in the organization has a clear idea about what is expected from him/her and how he/she will be judged.

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3. Providing Basis for Performance Evaluation:

It provides a basis for the comparison of actual performance with pre-determined budgets and helps find out the deviation, if any, between actual performance and the budgeted figures. It helps to take remedial measures.

4. Economic Use of Resources:

It ensures best possible use of available resources to maximize the profits of the organization, which ultimately promotes operational efficiency.

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5. Coordination:

It promotes coordination of various activities of the business by centralizing control and also makes a facility for the management to decentralize responsibility by delegating authority.

6. Motivation:

It motivates employees because they also play a vital role in the preparation of budgets.

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ii. Disadvantages of Budgetary’ Control:

Mentioned below are the disadvantages of the budgetary control system:

1. Estimate-based:

Budgets are based on future estimates. The assumptions about future estimates may or may not actually happen.

2. Rigidity:

Rigidity in budgetary control poses problems in performing day-to-day operations.

3. Lack of Coordination:

If workers are not properly motivated a lack of coordination is visible within the organization. It also creates problems if responsibility is not properly delegated.

4. Expensive:

The introduction and implementation of this system is very expensive.

B. Return on Investment:

Return on investment (ROI) is one of the important tools of financial control. It evaluates the efficiency of an investment.

It can be calculated by using one of the following formulae:

Return on capital employed [ROCE] = EBIT / Capital employed x 100

Here, EBIT = Earnings before interest and taxes

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Return on equity [ROE] = Net profit after taxes / Net worth x 100

Comparison of ROE or ROCE with the other companies operating under same industry helps evaluate the efficiency with which the long-term funds are utilized.

i. Advantages of ROI:

The following are the advantages of ROI:

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1. Efficient Use of Capital:

It focuses managerial attention on the earnings of best possible profit on the available capital rather than mere increase in sales volume or cost reduction.

2. Guide for Capital Efficiency:

It is an absolute guide to judge capital efficiency. It helps compare the efficiency of the capital within the company over the years and with other companies in the same year.

3. Comprehensive Technique:

It is a complete financial control technique and has the impact of all the factors having bearing on return.

ii. Disadvantages of ROI:

Despite having many advantages and wide application, this method is not fool proof. It suffers from the following disadvantages:

1. Difficulty in Setting Standards:

Setting a standard rate of return on investment is a difficult task and hence a meaningful comparison of ROI is not possible.

2. Dependence on Profit:

ROI is calculated using profit and hence if profit is not computed accu­rately then ROI will also be misleading.

3. Difficult in Knowing the Volume of Investment:

ROI gives us a percentage figure. A big firm having a large amount of investment may have same ROI as a small firm having smaller amount of investment.

C. Break Even Analysis:

Break even analysis is a financial control technique that shows the relationship between cost and revenue to formulate planning. It is that analytical technique which indicates the level of production or sales where no profit or loss occurs for a concern, i.e. the point at which sales will be equal to the total costs. Break even analysis has been shown in Figure 12.2.

Breakeven point, E, is that point where the firm neither gains nor loses anything, i.e. sales line and total cost line intersect here. Angle of incidence indicates the volume of profit: Greater the angle, greater will be the profit and vice-versa. Break even analysis can be used for taking very important decisions such as make or buy, shut down point, acceptance of an order, etc.

i. Advantages of Break Even Analysis:

The advantages of break analysis have been discussed below:

1. Assistance in Decision Making:

Break even analysis can be used for making many important managerial decisions, like make or buy, shut down point, acceptance of an order, etc.

2. Determination of Profit.

It helps determine the amount of profit at different levels of activity.

3. Fixation of Selling Price:

Break even analysis presents the information in a manner that helps fix the selling price of the products or services to earn a desired amount of profit.

4. Cost Control:

It is also used to control the total cost by proper utilization of fixed costs.

5. Comparison:

It helps compare the profitability of different firms operating in the same industry.

ii. Disadvantages of Break Even Analysis:

Though it is an important tool of financial control Break even analysis suffers from following disadvantages:

1. Faulty Assumptions:

The assumptions on which Break even analysis is based are unrealistic such as fixed cost remains constant; variable cost varies proportionately with production, etc.

2. Unrealistic Technique:

This technique cannot be used for control in isolation. It can be used as a supplementary tool.

3. Nature of Firm:

This tool of financial control ignores the nature of the firm, i.e. whether the firm is growing or declining. Here it has been assumed that a firm always remains constant.

4. Unsuitable for Multiproduct Firms’:

This technique cannot effectively be used where a firm pro­duces more than one product with same plant and machinery and having different contribution margins.

D. Ratio Analysis:

Ratio analysis is one of the important tools of financial control and is used to judge the financial per­formance of an organization. Ratio is computed by taking the proportion of one financial variable with another related financial variable.

By calculating the ratio between two related financial variables, useful interpretation can be made which ultimately helps make appropriate decisions. Financial variables are collected from financial statements such as profit and loss account and balance sheet.

i. Advantages of Ratio Analysis:

Mentioned below are the advantages of ratio analysis:

1. Tool of Management Control:

It facilitates control over different activities by identifying strengths and weaknesses of the firm.

2. Assistance in Preparing Budget:

Helps in the preparation of the budget because different ratios act as a guide for determining budgeted figures for different activities.

3. Assistance in Determining Financial Performance:

Ratio analysis helps judge the liquidity, solvency and profitability of a concern.

4. Comparison:

It is very helpful for making a meaningful inter-firm and intra-firm comparisons.

ii. Disadvantages of Ratio Analysis:

The following are the disadvantages of ratio analysis:

1. Faulty Future Forecast:

Ratios calculated on the basis of historical figures cannot predict the future precisely. So, other related factors and policies must be considered for future forecasting.

2. Time-consuming:

A single ratio cannot predict an incident accurately. A number of supporting ratios are also calculated to predict an incident. So the ratio analysis becomes a time-consuming affair.